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Bank of Japan offers forward guidance but little else

In the event, the BOJ underwhelmed and the policy rate was held at minus 0.1%

USDJPY rose to 102.65 and the 10-year government bond yield moved above zero

With the BoJ meeting done, now for the US Federal Reserve

Expect no rate hike and a statement that suggests December is still live

By Max McKegg

As lunchtime came and went in Japan today without a statement from the Bank of Japan, anticipation grew that the board was busy putting the finishing touches on a significant announcement following a two-day “comprehensive assessment” of current monetary policy. USDJPY traded nervously around 100.70.

USDJPY jumped to 102.65, the 10-year government bond yield moved up to just above zero and the stock market rose 1.5%.
Photo: iStock

In the event, the BoJ underwhelmed again. The policy rate is to be held at –0.1%, “yield curve control” is to be introduced with a target of zero for the ten-year government bond, the current pace of bond buying will continue and “forward guidance” will be enhanced.

USDJPY jumped to 102.65, the ten-year government bond yield moved up to just above zero and the stock market rose 1.5%.

Like most central banks, the BoJ prefers to make significant policy adjustments at meetings where updated economic forecasts are presented. Hence the modest action today. The next forecast updates from the BoJ are scheduled for November 1.

However, today’s interim meeting had attracted more interest than usual because of the promised comprehensive assessment of monetary policy, in particular “why the price stability target of 2% has not been achieved yet despite unprecedentedly large-scale monetary easing”. The inflation target itself was not up for discussion; just the appropriate “transmission mechanism” to achieve it.

The policy assessment was timely given that inflation has been drifting slowly but surely back into negative territory. The latest reading on the BoJ’s benchmark (CPI less fresh food) showed it had dropped by 0.5% year-on-year while the core rate, which excludes energy prices, was also trending down.

Japan's inflation

Source: PIMCO

Of more concern to the BoJ is the recent decline in inflation expectations, brought about, they say, through an “adaptive formation mechanism” whereby inflation expectations are strongly influenced by the current inflation rate. In other words, consumers and business are acting on the assumption inflation will remain low and are not putting much weight on the BoJ’s promise to do whatever it takes to reach the 2% target.

This is in contrast to the situation in the US, where inflation surveys show inflation expectations are anchored around the Federal Reserve’s 2% objective even though the current rate is barely half that.

The BoJ’s strategy to overcome this “deflationary mindset” has been to purchase large quantities of government bonds, thereby driving interest rates lower across the yield curve. The actual target is the real rate of interest – the nominal rate less inflation expectations. The bank wants to push the real rate down deeply into negative territory as a spur to economic activity. The trouble is inflation expectations have been following interest rates down so that the real rate is still slightly positive.

That’s the crux of the problem for the BoJ: how to get some runs on the board so that consumers and business will take seriously the inflation target and adjust their behaviour accordingly.

Driving down interest rates across the yield curve can have a significant impact on financial institutions, especially those whose business model is borrowing short and lending long. The monetary policy assessment was to look at this issue as well, and in anticipation of some BoJ action to take pressure off the banks by steepening the yield curve, traders had pushed the yield on ten-year government bonds up from –0.30% a few weeks ago to almost zero leading into today’s announcements. This coincided with an apparent lack of urgency on the part of the European Central Bank to expand its QE program, resulting in the German bund yield also moving back up to and slightly past zero. Modest rate rises in these two heavyweight markets have flowed through into global rate structures.

In the lead-up, two of the 23 primary dealers who trade directly with the Fed predict a rate cut today, while fed funds futures pricing suggests a less than 20% chance of that happening (the doted line on the chart below). But as the chart shows, since 1994 market pricing has always been closer to 80% prior to rate moves, either up or down (a reading over 100 occurs when the market prices in some chance of a 50-basis-point move).

Federal Reserve rate hike odds

Source: Goldman Sachs

So a rate hike today would suggest the FOMC has failed to communicate effectively with the market or has conspired to get a bigger bang for their buck by wrong-footing traders. A better explanation for a move today would be that heading into the meeting, no one, not even the Chair, had a clue which way the 10 voting members would go and therefore was unable to guide the markets.

Expect this: no rate hike; a statement that suggests December is still live; economic projections out to 2019 showing a dot-plot curve 25 basis points lower than June’s and guidance from Janet Yellen that the FOMC thinks the medium-term neutral or normal rate of interest is 2% to 3% and they are in no hurry to get there.

My chart analysis of USDJPY appears below:

USDJPY (click to expand)

Source: ThomsonReuters. Create your own charts with SaxoTrader; click here to learn more

An insightful commentary on the situation in Japan. You do an excellent job of providing "live" coverage on NZD, AUD and JPY events in particular Max. You're based in Australia aren't you ? I guess that time zone helps. As a general comment, this Trading Floor site seems to be european-centric, going "off line" as soon as the european markets close - as if nothing happens in the second half of the US trading day !! (although I presume someone there will stay on deck tonight to cover the Fed meeting........). I look forward to your assessment of the RBNZ statement.tomorrow. I've put on a trade based on your NZDUSD daily forecast.

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